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11/14/2010

Quantitative Easing—Posner

“Quantitative easing” is a pompous, uninformative term for a central bank’s buying debt (bonds, mortgages, commercial paper, etc.) in quantity in an effort to depress interest rates in order to stimulate economic activity. Recently the Federal Reserve began buying $600 billion (for starters) worth of long-term Treasury bonds. It is buying them with money that it creates by a computer stroke. That money will expand the money supply relative to the output of the economy and thus (depending however on how rapidly the money circulates) increase inflation, which in turn will reduce the burden of fixed debt and, it is hoped, thereby encourage people to spend more. In addition, by increasing the demand for bonds, the program will increase their price, which in turn will reduce their return; bonds are fixed-income debt, so as the price of a bond rises, the interest it yields, being a fixed amount, becomes a smaller percentage of the price. So interest rates will fall, stimulating (it is hoped) borrowing and hence spending. Finally, by increasing the world supply of dollars, the purchase of bonds with cash newly created by the Fed will reduce the value of dollars relative to other currencies, thus making exports of American goods and services cheaper and imports of foreign goods more expensive. As Becker points out, anticipation of inflation leads owners of dollar-denominated assets to sell those assets, which further increases the amount of dollars in the world economy relative to other currencies.

The first and third effects are probably more important than the second, the effect on long-term interest rates. Those rates are low in part because short-term rates are very low and there is considerable substitution between short- and long-term loans. Moreover, the modest incremental effect on long-term interest rates of increasing the demand for and thus price of long-term bonds may be offset by the effect of enlarging the money supply in causing inflation expectations to rise, which in turn increases interest rates.

The first (inflation) and third (devaluation) effects of the new program are not emphasized by the Fed because of their sensitivity. Since the financial collapse of September 2008, the Fed has been pouring money into the economy, and as a result its total assets (mainly bonds of various sorts) have soared to $2.3 trillion. The new quantitative-easing program may push the total well beyond $3 trillion (remember that the $600 billion is just the initial implementation of the program). This will not necessarily cause an immediate increase in inflation, because much of the money supply is as a practical matter frozen because of uncertainty about the economic environment. The banks are sitting on $1 trillion in excess reserves (in effect, lendable cash); large corporations have large cash hoards as well; and the personal savings rate has increased severalfold in the last two years. Money that is hoarded rather than spent does not increase inflation. If the Fed creates $1 in money and the private sector responds by increasing the amount of saving by $1, there is no effect on inflation because there is no increase in the number of dollars that are chasing the goods and services produced by the economy.

Even if there is reluctance on the part of the private sector to spend the new money pumped into the private economy by the Fed’s new program, there probably will be at least a small uptick in inflation because of expectations of a future increase in spending and hence in inflation. This can be a good thing by lightening fixed debt, such as mortgages that carry a fixed rather than adjustable interest rate. The less debt people have, the less they will save and so the more they will spend. Increased consumption will lead in turn to increased production and hence increased employment, resulting in higher incomes which in turn will spur more consumption.

Similarly, the devaluation of the dollar will increase the demand for U.S. exports, which in turn will spur production, and there will be a further effect of increasing production because of the reduction in imports; and some of that reduction, moreover, will induce increased domestic production aimed at satisfying demand formerly supplied by imports.

So “quantitative easing” is a rational response to a depressed economy with stubbornly high unemployment and very low inflation. But that doesn’t mean it’s a sensible response. There are three principal objections to the new program. The first is that the inflation that it aims to increase by a slight to moderate amount may get out of hand. Suppose businesses and consumers increase their spending, and the banks lend the $1 trillion they’re holding in excess reserves (accounts in federal reserves banks, equivalent to cash). The ratio of money in circulation to goods and services will rise, and inflation will tick upward, perhaps more than desired. The Fed can reduce the money in circulation by selling some of its huge inventory of bonds, but by doing so it will raise interest rates (just as increasing the demand for bonds lowers interest rates, increasing the supply raises them), which may choke off the economic recovery. If it hesitates to sell bonds and retire the cash it receives from the sales, expectations of inflation may soar, and inflation rise to a dangerous level; and to bring it down the Fed will then have to sell bonds after all, draining money out of the private economy at a rate that brings on the kind of very sharp recession that the nation experienced in the early 1980s.

No one knows or can know whether the Federal Reserve can walk such a tightrope. Even if it can do so as a technical matter, political pressures may cause it to fall off the tightrope. The Fed will be subject to greater political pressures, beginning in the near future, as a result of the financial regulatory reform legislation passed earlier this year, which by giving the Fed regulatory authority over financial institutions that are not commercial banks is increasing its political exposure.

The second objection to the new program concerns its effect on the role of the United States in the global economy. Nations such as China, Germany, and Japan that are large exporters are irate at our devaluing our currency by increasing the world supply of U.S. dollars. They are capable of retaliating, and if as a result our trade balance does not improve significantly the program of “quantitative easing” may end up having no beneficial effect other than to increase inflation, which may as I said get out of hand.

Moreover, the U.S. dollar is the major international reserve currency. That is, it is the currency in which many international transactions not limited to transactions with U.S. firms are denominated because of the stability of the dollar. The status of the dollar as the international reserve currency requires foreign central banks to buy dollars in quantity so that firms in foreign countries can buy dollars for their international transactions. The dollars accumulated by central banks in turn are available to be lent back to the U.S. Treasury (by purchase of Treasury bonds from it) to help finance our huge national debt. If we manipulate the value of the dollar to improve our trade balance, we undermine confidence in the dollar’s stability, and the demand for dollars as a reserve currency may fall.

The third and perhaps biggest objection to the program of quantitative easing is that it relaxes the pressure on our politicians to address urgent issues of economic reform. The politicians are sitting back and letting the Fed try to hoist us out of our current economic hole. The pressure to respond to the urgent need to put the health reform and financial regulatory reform programs on hold because of the debilitating uncertainty that they have injected into the business environment, and to take effective steps that will be politically painful (for they will include entitlements reform) toward increasing the rate of economic growth and reducing the rate of increase of the national debt, is being blunted.

These objections might recede in significance if “quantitative easing” could be expected to stimulate the economy. But that seems unlikely. Banks and corporations are awash with money. Their reluctance to lend because of the uncertainty of the business environment is unlikely to be overcome by a further and probably modest reduction in long-term interest rates—modest because of the substitution effect I mentioned earlier and because the bond-buying program will increase expectations of future inflation, which in turn will push up long-term interest rates.

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Trenchant analysis. The biggest difference between today and the pre-Volcker oil shock in the '70s is the trade deficit. I think some Austrians underestimate the effect of the Chinese peg on structure in the US. Only point to add is that much of the cash reserves on US corporate balance sheets is abroad and cannot be repatriated without a big tax hit.

QE2 most certainly will increase political pressures on the Fed. Given the breathtaking manner in which they have departed from their original mission to promote price stability, and the morally dubious effort to "rescue" the economy at the expense of savers and retirees, opprobrium is not only to be expected, but, in my opinion, deserved.

I completely agree with the above comment, the internet is with a doubt growing into the most important medium of communication across the globe and its due to sites like this that ideas are spreading so quickly.

Of course QE2 is the right approach. Only a traitor would be worried about its impact on China and Germany.

There is no chance of inflation, with 15/17% unemployment.

The purpose of buying bonds is to force other market participants to buy something else as a weapon against Chinese and Germania Mercantilism.

Take China. Roughly speaking it has only the following choices. 1)it can buy a US bond, getting no return 2) buy a Euro bond, getting a reduced return, 3) spend the money on a US import (directly or indirectly) or 4) hold cash. In fact, there is a better step than buying bonds. The Fed ought to just print trillions in new hundreds, put the currency on pallets, and send it to China in all the empty containers lying around, paying off our debt. What could China do with the money in that form? IOW QE2 is simply a way to force China to spend, not hoard.

If China takes the money and goes to Australia, buying iron ore, the Aussies are smart enough to say, price has gone up, you thief. People who fence stolen goods make the seller take a hell of a hit. The Aussies now have the cash. What can they do?

In sum, when you are the reserve currency you can use such as a very effective weapon to correct Mercantile behavior.

Bernake obviously read Clavell's Tai Pan, which has the great scene where the Tai Pan's notes are called, but the note holder lacks the security to keep the pirates from stealing his silver, if he takes payment from the Tai Pan.

Obviously, the Feds actions are going to be very painful in China and Germany, but they are big boys. To side with the enemy, the very fact that both oppose QE2 argues for its favorably, is an act of treason

Ha! John complete agreement! I was about to post the "coincidence" or other? that the Fed action harmonizes well with the the President's speeches in India and Indonesia........ a warning shot across the bow's of those who'd repeat history of the 30's with "beggar thy nation" attempts to export their unemployment problem to other nations.

"There is no chance of inflation, with 15/17% unemployment."

"Surprising" to many economists there was little to no inflation during the 4-5% unemployment years and the explanation is fairly simple; "we" have a nearly infinite supply of labor available around the world. Some come here under H1 work visa while Ha! some just come and other work is shifted via glass fiber and other means.

If, miraculously, new home starts were to double (ie become one third the number of the peak years) contractors and subs would be competing hard with sharp pencil bids for the work, subdivisions now laying fallow would be sold at lower prices than a few years ago.

I'm sure that if Dell, Intel or MSFT had to double production in a year or so, it would not pose a problem and the product would be sold at or below current prices.

Oil could spike, but, of course that is an external pricing issue, not one of too many dollars chasing too few goods, and the reaction to such an increase should not be "fighting inflation" but to just let the price increase work its way through the economy, hopefully, spurring yet more efforts to curtail its wasteful consumption.

Lastly, as for "too many dollars" not long ago folks had something on the order of $7 trillion in capital that no longer exists, AND they had jobs, perhaps even the hopes of advancement........ and "we're" hand wringing over half a trillion of bond purchases??

Seems those that have a pile or those protecting them? worry far more about pile-shrinkage than they do about others having a job.

So barely a day after the electorate signals that perhaps the macroeconomic manipulation policies of taking from Peter, wasting half of it, and giving the other half to Paul, is perhaps not a productive economic policy,

an unelected agency shrugs it all off and decides to pass Stimulus II,

Does it really make that much of a difference whether you spend money that you borrow or money that you print? In either case you spend money that is above and beyond your long term productivity trendline. In either case you are spending money against exceptional future production.

But where is this above average future production going to come from when incentives to produce keep decreasing, as the consequences of not producing are being blunted, while the burden (taxes) for engaging in high value work keeps increasing?

The most virulent of the welfare state viruses has already infected the US: Obamacare. There is little chance of repealing it before 2014, the year when this virus comes out of its incubation period and creates the greatest dis-incentives to be productive in a few generations. That is the year where a lot of suckers who insist on making more than 88K per year will pay for those who choose to drop their incomes below that level. Such a progressive invitation to create less wealth is rare in the developed world, even in the European Welfare states.

Meanwhile 3 billion people are going from once dismal, to now moderate incentives to produce and are springing up like a long squashed coil

How many investors and foreigners, and for how long, are going to be fooled by these macroeconomic gimmicks of taking from one pocket, wasting some, and then putting the remainder in the other pocket? That is the 15 trillion question and the next (perhaps “The Mother of All” this time) crisis.

To take an analogy from astronomy, will the US fade away as a red giant star (a sustainable low growth European style welfare state) or will it collapse on its core to blow up like a supernova? In astronomy at least, big stars tend to become supernovas…

So which one of the two decline scenarios will the US follow? In some ways the second one may hold better hope for a Phoenix like re-generation.

“We regret to inform you that your delayed reward for saving, i.e. postponing immediate gratification during a finite life, has just been reduced. We continue, however, to rely on savings to fund the unique American spirit of entrepreneurship and innovation, reduce the debt etc. Therefore, we hope that you will continue your, now ever more altruistic, participation in the public good as a saver.”

Sincerely,
The FED,
on behalf of a hurting public

The reduced reward comes in the form of lower returns and/or higher risk compared to what you anticipated when you were saving the money in the first place.

As they say, you can fool some people all the time and you can fool a lot of people some of the time. But there just aren’t enough people to fool enough times to have a prosperous life on the backs of those who forfeit immediate gratification in a finite life.

The bill of decline will come due sooner rather than later. Whether the bill is decline in the form of sustained low average growth or a series of intense crises separated by relative calm, or some combination of the two, remains to be seen. But one thing is certain: Higher prosperity founded on decreased incentives to produce is impossible.

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A falling dollar creates losses for foreign holders of UST and other US financial assets. If the dollar falls far enough, and the prospects for its recovery seem dim, foreign holders will switch out of low-yielding UST (negative yielding, when currency translation is taken into account), leaving the Fed a larger and larger share of the UST market unless yields rise sharply. The Fed cannot both devalue the dollar and artificially depress UST yields for any period of time.

Manufacturing is now less than 12% of GDP. The prospects for increased exports of goods seem poor. I question whether a devalued dollar will sharply increase foreign purchases of US services. The sad truth is the primary export of the US for many years has been IOU's.

Americans seem unaware that foreign suppliers can invoice in their own currencies, and will do so if the dollar falls far enough.

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Thanks D. Stone for illustrating that increasing the money supply has its victims. As Posner correctly observes, the whole purpose of quantitative easing is to (further) reduce interest rates in the short term. It punishes those who have saved and invested those savings, reduces the value of the dollar and rewards the debtor class. Ultimately, if QE succeeds in accomplishing what it is intended to do, those who have deferred gratification by saving rather than spending will be punished yet again when inflation is unleashed. The Fed has already pushed the small investor from previously "safe" bonds into more risky higher yielding ones. Except for a handful of very well informed or lucky investors, when the switch from low interest rates to high inflation occurs, few ordinary savers will be able to re-align their portfolios to avoid further damage. Is this the type of incentive/reward system the Federal Reserve was established to promote?

Think of QE2 as a shortening of the maturity of the federal debt. The Fed creates short-term liabilities for the government (reserves) and uses the funds to reduce longer-term liabilities by buying up Treasury notes and bonds. Is this a good or a bad idea? To the extent the purchase of Treasury notes and bonds reduces interest rates charged to private sector borrowers and stimulates spending, that's great. However, the shortening of maturity of the federal debt creates interest rate risk for the federal government--the risk that the debt will have to be refinanced at a higher interest rate. Arguably, for a government facing an issue of longer-term fiscal sustainability, a better policy would be to take advantage of historically low interest rates and lengthen the maturity of the federal debt--finance as much as possible with 30-year bonds so that we're less vulnerable to a loss of confidence. The problem with this policy, of course, is that to the extent that issuing more long-term debt increases interest rates, spending is curtailed and the economy further weakens. That's the trade-off. Which policy is best depends to a large extent on how sensitive long-term interest rates are to the supply of long-term Treasury debt. Low-sensitivity would argue for lengthening the maturity of the debt to lock in low interest rates; high sensitivity would argue for shortening the maturity (QE2) to stimulate the economy.

"These objections might recede in significance if “quantitative easing” could be expected to stimulate the economy. But that seems unlikely." the reason that why quantitative easing is not going to work is that, still a majority of the people, they have not yet adjusted their expectations. As these professors explain, banks and corporates they are sitting on piles of money, a money which is going to lose its value gradually.
Again, even if the symptoms of this crisis are like the ones as before, but that does not mean "at all" it has the same nature as the previous ones.

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I do not wish to start a "comment war" with anyone, but I feel compelled to note the inappropriateness and incivility from someone identifying himself as John. He writes that "[o]nly a traitor would be worried about its [Quantitative Easing 2] affect on China and Germany," and that "the traitors here just don't get it [in their opposition to QE2]."

In a previous comment for Posner's blog post "The New Congress and Economic Growth" (11/7/10), John writes that "Posner shows deep senility and madness..." for merely suggesting that there is a practical limit on economic growth; economists generally accept that long term economic growth is constrained no matter which buttons and dials the government decides to press and tweak.

Isn't there someone (an administrator perhaps) who reads the comments section and removes inappropriate comments? Don't people do that for sites like CNN and the NFL? I would hate to be in Posner's position of posting thoughtful commentary and then to be called a senile traitor on my own web page in return.

As our Feds put out an $800 billion stimulus, not entirely deployed as yet, and our beleagured cities, counties, and states have necessarily cut an equal amount what is the net stimulus?

After arriving at the answer please adjust for:

A. the American consumer feeling poor due to R/E, and retirement account equities having been lost entirely or halved.

B. the 10% unemployment and 18% "underemployment" with one in three households being impacted by the loss of a job since the financial sector melt down.

Post net-net "stimulus" here:

Greece sez: "Whereas the 0.3 billion people of the US are going from once good incentives to produce to now ever more blunted incentives to produce..."

++++++++ Indeed! For all too many being told their services are no longer required does reduce one's incentive to produce. You don't care much for stimulative spending on long delayed infrastructure maintenance and upgrades or the needed transition from burning the last of our fossil fuels to a more sustainable, less polluting source; what do you suggest?

++++++ Mitchell as you can quickly see I favor free speech, as for the NFL it's a cozy club made up of already wealthy private owners becoming yet wealthier because they've free access to our broadcast airwaves and which exists under anti-trust exemptions. I'm sure censorship is a part of their gig.

Quantitative easing is aimed at funneling more of the assets owned by the middle class into the pockets of the lower class and the financially elite class. QE is aimed at impoverishing Main Street in order to enrich Wall Street and its Prime Dealers.

It is routine for right wingers like Posner to refer to opponents as traitors. Why is is wrong for those of us in the center to refer to his as a traitor, especially when he is advocating for policies against the interest of the United States.

Posner is a traitor, for he favors economic policies that favor China and Germany, as opposed to Americans. He is publicly taking sides for China and Germany against the United States.

So are you. Obama, whom I don't support, has been called every name in the book by Posner and his kind and you and your kind and you have never said a peep. The shoe clearly now fits you.

We are in a war for our economic survival, against pernicious mercantilism and worse.

As for "economists generally accept that long term economic growth is constrained," this is BS, brought to us by the same economists that couldn't foresee the reasons for the Great Recession.

Patton said it best:

If everyone is thinking alike, then somebody isn't thinking

Economics has no tools to estimate the potential productivity of our knowledge based societies. Drucker said as much, often.

If the Chinese can build a hotel in 6 days, there is no practical limit to what our society could do, if people came to understand that it is people like Posner who are holding us back. He is negative, negative, negative to the core, and more than a little dishonest.

Our present levels of debt are meaningless, when one looks at the percentage of GDP going to pay the interest.

All the nattering nabobs of negativism make me sick. Any first year student of economics learns that there is no such thing as economic stability. Prices and fortunes move, constantly. All we can do, in Bhide's word, is Hustle.

The disinformation of worrying about savers when 15/17% or more or our people are unemployed is so misplaced it is immoral, especially as the only people with savings are the rich who have profited mightily the last 30 years.

The right winger are cowards and whiners; the Tea Party spoiled brats.

Posner's judicial philosophy is what made the Great Recession happen. All the actors, the investment banker, directors, officers, appraisers, all acted criminally, because the legal handcuffs on dishonest conduct had been removed by Poser and judges of like mind.

In closing, Patton said

Prepare for the unknown by studying how others in the past have coped with the unforeseeable and the unpredictable.

That is a great economist like Keynes did.

The solutions are often counterintuitive and inverted.

The head of the NY Fed was on CNBC this morning and said it straight up. We are buying all the bonds to force China and others to have to buy other assets.

This means we are finally playing offense and its is going to force China to make choices that can only be good. For example, if China buys Euros, instead, it may help to a solution of the problems in Ireland, Greece, etc., by lowering their interest rates. If China buys Yen, Japan will strengthen against China and contain its worst sides.

Commodity prices and oil may rise in price, but that is going to happen because of demand, unless we find new sources of supply or alternatives.

If, for example, you are worried about oil prices, then you should be supporting Boone Pickens and nuclear power, not harping about "inflation" that merely delays the inevitable

"The disinformation of worrying about savers when 15/17% or more or our people are unemployed is so misplaced it is immoral, especially as the only people with savings are the rich who have profited mightily the last 30 years."

++++Indeed and much of the profit from utterly unproductive financial manipulation. It's a shame we don't have a wealth tax in order to claw some of it back. Lacking such, it's time for top level gleaners to (at least) return to the tax rates of the Clinton era. It won't hurt a thing.

"Economics has no tools to estimate the potential productivity of our knowledge based societies. Drucker said as much, often."

+++++++++ Yes! Seeing the future has not been easy. IBM's quite savvy Tom Watson saw post war need for computers to be half a dozen and the best positioned company largely missed the PC revolution and Ha! refused to buy Gates "overpriced" DOS. Bell execs were pleased when an early internet demo failed, and walked off calling it a toy. And, who'd have predicted even 5 years in advance the cellphone explosion or that bulky $2,000 video cams would be shrunken to fit in a phone and given away?

"Commodity prices and oil may rise in price, but that is going to happen because of demand, unless we find new sources of supply or alternatives.

+++++++++ And implement strong conservation measures. While the US won't be able to halve our fuel consumption per GDP to rates of Europe and Japan, it IS a national security issue to head rapidly in that direction.

If, for example, you are worried about oil prices, then you should be supporting Boone Pickens and nuclear power, not harping about "inflation" that merely delays the inevitable"

++++++++ Boone favored NG as the "bridge fuel" for heavy transport. We in Alaska have been trying to PUSH oil companies into building the long discussed 52" pressurized pipeline that would connect with Canada's pipelines to deliver the cheap, domestically produced gas we KNOW is on the N. Slope (where much of it has been re-injected) for ten or more years.

Consider the boost to our economy of a $40 billion project in NAmerica would bring NG to the Mid-west which would be paid for by NG for the next half century. Were we to adopt Boone's suggestion and begin, now, to shift trucks over to multi-fuel (As Brazil's entire fleet is) we'd be retaining petro dollars now going "over there" and! were oil to soar or much of it cut-off by problems in the Suez or off the Iranian coast our heavy transit would continue to operate on its choice of fuels.

Curling up like a sowbug is only the defense of unimaginative sowbugs.